Scavenging for Bargains

Forget Kahala, Glacier Water is the merger arb of the year

In June I called Kahala the merger arbitrage idea of the year, but of course when you call something the idea of the year in June you risk that something better comes along later on. Kahala proved to live up to it’s expectation: I got cashed out at $159.82/share while I entered my position at $139.07: a return of 14.9% in less than two months time. Pretty awesome, but the deal presented by Glacier Water Services (OTC:GWSV) might even be better. The company is being bought by Primo Water (NASDQ:PRMW) for a mix of cash, stock and warrants.

The exact amounts are not yet known because some adjustments are made for transaction costs incurred by Glacier and any additional debt incurred by Glacier after the date of the merger agreement. These complexities and also the accompanying uncertainties are without a doubt part of the reason of the high spread. In Kahala the merger agreement had similar provisions, and the fact that both stocks are highly illiquid adds another parallel.

A simple calculation

Before making this story complex, we can first start with estimating the value of the merger consideration simply based by the estimates provided in the S-4 that was published by Primo Water. They provide the following estimate:

$12.13 in cash, which is referred to as the “Per Share Cash Amount;”

0.87 of a share of Primo common stock, which is referred to as the “Per Share Stock Amount;” and

a warrant to purchase 0.54 of a share of Primo common stock, which is referred to as the “Per Share Warrant Amount,”

The first two items are very straightforward, while we have to do a little bit of math the figure out the value of the warrants. The warrants have an expiry date 5 years after the completion of the merger and have a strike at $11.88. With Primo Water trading at $13.05 at the time of writing this, it should be obvious that these warrants are quite valuable. They are already a decent amount in the money, and they also have a huge amount of time value. If we add these variables in an option calculator, and use a volatility of 41.7% (the historical volatility of Primo Water this year), a interest rate of 1.27% (the yield on 5-year US government bonds) and a 0.0% dividend yield a warrant for one share would be worth $5.35.

This would give us the following total merger consideration:

Cash: $12.13

Stock: 0.87 * $13.05 = $11.35

Warrant: 0.54 * $5.35 = $2.89

Sum: $12.13 + $11.35 + $2.89 = $26.37

Since Glacier Water is at the time of writing this trading at $22.48 the spread is 17.3 percent!

The nitty gritty details

Transaction/debt adjustment

Of course, things aren’t quite as straightforward in this case. The biggest complication is that both the cash consideration and the stock consideration are adjusted based on the transaction expenses incurred by Glacier water and any additional net debt that is incurred after the transaction date. Primo Water is offering a closing consideration of $86,090,904 of which 58% is payable in cash and 42% is payable in stock. The Closing Cash Consideration and the Closing Stock Consideration are defined as follows:

“Closing Stock Consideration” means the number of shares of Purchaser Common Stock determined by (A) calculating an amount equal to (x) the Closing Consideration Value multiplied by the Stock Percentage plus (y) the amount of the Transaction Expense Exclusion, and (B) dividing such amount by the Average Share Price. For purposes of calculating the definition of the Closing Stock Consideration pursuant to this Section 1.6(e)(vi), if inclusion of the Transaction Expense Exclusion in the value of the Closing Stock Consideration would require the Purchaser to obtain stockholder approval of the transactions contemplated by this Agreement pursuant to Nasdaq Marketplace Rule 5635 and such stockholder approval has not been obtained, then the Transaction Expense Exclusion shall be omitted from the definition of Closing Stock Consideration and shall instead be included in the calculation of Closing Cash Consideration as an addition and not a reduction to the calculation thereof.

From the $49,932,724 cash consideration the transaction expenses are deducted together with any new net debt. At the moment both parties expect that Glacier will not incur any new net debt, and that the total adjustment for the transaction costs will total $5,600,000. This amount also contains the “Transaction Expense Exclusion” of $1,750,000 which is added back to the stock consideration. So the closing cash consideration will be $44,332,724 ($49,932,724 minus $5,600,000) while the closing stock consideration will be $37,908,180 ($36,158,180 plus $1,750,000). To determine the number of shares that will be delivered to pay this consideration an average share price of $11.88 will be used. The number of warrants that will be delivered is not subject to any adjustments and it’s simply a total of 2 million.

Now we only need to know the number of shares that will be outstanding immediately before the merger and we can calculate the value of the various components. The number of shares outstanding at 6 October was 3,316,916. The company expects that Glacier will issue 69,400 bonus shares in connection with the merger, and there are 214,129 minority units outstanding. In addition to this there are 157,438 options outstanding with an average strike price of 15.45. These will be converted into shares based on the value of the stock and the cash component of the merger (the warrants are ignored). The per share merger consideration is roughly $12.13 plus 0.87 * $13.05 = $23.48. Now the number of shares issued for the options can be calculated as follows: (($23.48 – $15.45) / $23.48) * 157,438 = 53,858. Now we can add everything and we find a total of 3,654,303 shares that will be outstanding before the merger.

Divide the closing cash consideration of $44,332,724 by 3,654,303 shares and we get a cash component of $12.13/share, a number of 0.87 shares of PRMW per GWSV share and 0.55 warrants per share. This matches almost perfectly with the estimates provided by the company in the S-4 (as it should), but having done this math we can now also easily check what would happen if the adjustment ends up being lower or higher. If for example the adjustment ends up one million higher we get the same stock/warrant consideration, but just $11.88/share. So every million in additional expenses reduces the return by roughly 1.2%. Since the spread is at the moment roughly 17.3% the adjustment can increase by more than 14 million (a lot!) before the expected return turns negative.

Escrow

Because certain adjustments are made to the cash and stock consideration a part of the stock will be held in escrow when the merger is completed since at the time of the merger the exact amount of the transaction expenses and debt is not known. If the transaction expenses are underestimated it will be deducted from the stock held in escrow, while if it was over estimated Primo Water will make an additional cash payment. The main terms of the escrow agreement:

Primo will withhold from Glacier equityholders (on a pro rata basis according to their respective interests therein) and deliver to the escrow agent 71% of the stock consideration payable to each such Glacier equityholder, to be held and distributed by the escrow agent pursuant to the terms of the Merger Agreement and the escrow agreement. Subject to any claims for indemnification, the escrow will be released to the stockholder representative, on behalf of and for distribution to the Glacier equityholders, as follows: twenty-five percent (25%) of the escrow will be released on the date that is six (6) months following the Closing Date; an additional twenty-five percent (25%) will be released on the date that is nine (9) months following the Closing Date, and the remaining fifty percent (50%) will be released on the “Final Escrow Release Date”, which means (i) if the Closing Date is on or prior to December 31, 2016, the date that is the first anniversary of the Closing Date or (ii) if the Closing Date is after December 31, 2016, the date that is thirty (30) days following the completion of an independent audit of Primo and its subsidiaries on a consolidated basis following the Merger for the fiscal year ending December 31, 2017.

I don’t think that having a large part of the share based component in escrow represents a big risk factor, although that also could be overly optimistic. You could argue that apparently Primo Water thinks the escrow is required, so that implies that there is some probability that the escrow might indeed be required to pay for some unexpected adjustments. But even if you expect to eventually receive all shares in the end it’s for sure an additional complication since it could take more than one year before the last shares are released.

Warrants

A valuable component of the deal are the warrants because they are already in the money. These also have some complications that make them less interesting for those who want to do a “clean” merger arbitrage. One third of the warrants will vest 180 days after the merger is completed, another third will vest 270 days after the merger is completed and the last batch will vest one year after the completion of the merger. In addition to this the warrants might not become tradable, because in the S-4 it is stated that “The warrants to purchase shares of Primo common stock will not be listed on the Nasdaq Global Market or any other exchange.” I’m however not sure if this also means that they won’t become tradable on the pink sheets.

In the “simple calculation” I didn’t spent a lot of time on valuing the warrants, but I think that using the historical volatility of this year of 42% is probably a reasonable conservative guess. This year might have been a bit more volatility than normal thanks to the merger announcement, but on the other hand Primo Water will be more leveraged than today after the merger. The company will actually carry a big debt load, and having a highly leveraged company will be favorable for the value of the warrants since they will participate fully in the upside but the downside is limited. In addition to that I believe that the Black-Scholes equation tends to undervalue options that have a very long time before expiration remaining.

Voting and timing

I think the risk of this deal not closing is minimal. The deal is expected to close fast, before the end of this year, and insiders own 55.3% of the outstanding shares. They have already entered a voting agreement for 33.3% of the outstanding shares, and I guess the only reason that they haven’t entered a voting agreement for all their shares is some kind of legal one. But I think we can safely assume that the remaining 22.0% of their shares will also vote in agreement of the merger, and therefore insiders can approve the merger without requiring the consent of minority investors.

Conclusion

I think the Glacier/Primo merger is a deal that makes sense for both parties. They want to get it done, and they will be able to do so. The big uncertainty is not in if this deal will happen, but what Glacier shareholders will exactly get. However, I don’t think that this uncertainty warrants a huge spread. This is a classic case where it’s in managements best interest to be a little bit conservative in the estimate of the final payout. If you estimate for example a $12.13/share cash component and it ends up a little bit higher no-one will complain, if you are overly optimistic and it ends up a lot lower you might get sued. In addition to this management will be incentivized to minimize transaction costs and not incur additional debt since they have the most to lose/gain since they own the majority of the outstanding stock.

Of course, all the complexities, with among other things, the stock component that will remain in escrow and the warrants that have a vesting period and might not be tradable, makes this deal less attractive then if it would be a simply cash payment. If this deal would be a simple fixed cash payment with no strings attached I would say that a fair merger spread would be less than one percent. Accounting for the various uncertainties my guess would be that a five percent spread would be reasonable. It’s hard to pinpoint exactly, but I’m pretty sure that the current 17.3% spread is way too high and not even close to correct, and because of that I have made Glacier Water my largest position.

51 thoughts on “Forget Kahala, Glacier Water is the merger arb of the year”

A better way to approach this spread is thinking of the total consideration as purchasing Primo Water stock at a discount. What discount is fair given the very high multiple that Primo water trades at on an absolute and relative basis?

Given the stock escrow component of the deal, for the returns to actually be as high as you state, it’s predicated on the stock not dropping significantly in value over the next year. What are your views on the pro forma entity? Doesn’t seem like a compelling valuation to me, and could be a large reason for the spread.

These are 5 year warrants. How much would you charge someone in interest upfront for the right to play with $11.88 of your principal for 5 years? 5% p.a, 7%, 10%? Ignoring the moneyness completely, and using those rates which are lower than credit card rates, that’s $3 – $6. Remember, a warrant (call) is the same as buying the stock and buying a put, which is like the incredible position of not being on the hook for the $11.88 you’re essentially “borrowing.”

So while it’s wrong to use historical volatility in valuing equity options, particularly one with 5iyear term, the assumption in the post is not unreasonable.

I don’t think you should look at it that way; you could borrow close to the risk free rate through your broker so that’s also the gain you get if you don’t have to do that because you get the leverage through the warrants. That’s why you should value warrants/options using the risk free rate.

AV — I used to market-make FX volatility for a little while, so the B-S inputs/assumptions are somewhat familiar to me. I get the sense the model’s assumptions were convenient to standardize option contract pricing and make option exchanges possible (which in turn made the creators of the handicapping method very rich and famous). It makes sense to use the current risk-free rate for short-term options, however, it’s wholly inadequate for a long-term warrant. If Primo was issuing short term warrants that I planned to trade the minute they were out, yeah, totally agreed with your point. But this is different. If those warrants are tradable and they are heavily sold, well……

An alternative way to compare value across warrants is to take the premium as an imputed interest cost, reflecting what you would ordinarily charge someone — upfront — for the right to essentially play with your capital (i.e. the $11.88 strike price Primo is underwriting) for 5 years and without recourse. Borrowing from a broker is materially different; for starters, broker takes collateral & has recourse if the value of loaned securities fall below a certain “strike price.” Therefore, they necessarily should charge a lot less. Said another way, the service of broker lending isn’t worth nearly as much as writing me a call option.

That being said, $3-$6 for the Primo 5-year warrants is more than a fair valuation and so in this case, plugging in the high historical volatility + risk-free assumption into B-S model doesn’t interfere with that value. But imagine if the historical volatility was 10% because Primo was an unloved, uncovered stock, would that then mean the warrants are worth a lot less? Or inverting the question, would one happily sell a 5-year warrant for a lot less, because B-S suggests that opportunity cost is a risk-free bond?

Historical volatility is of course only a short cut to estimate future volatility. If the stock would have 10% historical volatility, and it would be expected to be equally boring in the future warrants would indeed be worth a lot less. If you would still buy them at a way higher volatility someone could sell them to you, delta hedge the warrant and be expected to make a lot of money.

An opportunity cost is not the same as the interest rate that you should use in your calculations to determine fair value. If I would say that my opportunity cost is 10%/year it doesn’t suddenly mean that government bonds are worth way less than par just because they now pay a fraction of that. It just means that perhaps (near) risk free assets are not a good investment for me personally. If you estimate the future volatility correctly you can turn a long/short warrant position also (sort of) in a risk free asset by delta hedging. That’s why you pay the insurance premium for the put that is embedded in the warrant, and not for the leverage that you also get.

PS. I actually think that maybe you can make a small case that perhaps here you should value the ability to get leverage a little bit higher. The warrants are probably the only practical way to get leveraged exposure to this stock because it’s not marginable at most brokers (I assume, haven’t checked it).

PPS. I don’t think you should see getting an call option as getting a fixed amount of money to play with. If the strike is at $11.88 and the stock is at $11.88 the delta of the option is roughly 50% so you actually borrow more like $6. If the stock goes up the delta goes up, and you get more exposure so you effectively borrow more, while if the stock goes down the delta goes down and you borrow less. So it’s not that different from getting a margin loan at a broker where the loan amount is also dependent on the value of the portfolio.

* I made no mention of delta hedging / volatility arbitrage. Those are short-term trading considerations which purposely choose to hedge away the value of the underlying asset, as though a warrant privilege’s worth lies solely on future volatility. Moneyness and volatility don’t have to move in tandem. By the way, it’s really not a vital consideration in this case since very impractical for small stock option markets, where illiquidity, volatility smile, erratic implied vol changes, etc makes delta hedging expensive and risky. That said, it’s a very shrewd consideration in more continuous markets like large-scale ccy pairs e.g. EUR/USD

* “An opportunity cost is not the same as the interest rate that you should use in your calculations to determine fair value…” Again, never suggested this. In fact, I’ve merely inverted the problem from the perspective of a option-writer. What’s the minimum you’d charge someone upfront for the 5-year privilege of taking all the returns — but none of the losses — of an asset you own which has a book value of $11.88? Justifying this minimum on the basis of what Interactive Brokers would charge its clients for collateralized, full-recourse borrow seems peculiar (to me). Nevertheless, in this case, doesn’t make much of a difference given high historical vol input assumption. In a low volatility alternative history, it would be no less peculiar, since you, as call option writer, are still lending use of the same asset. It runs counter to value investing that we would focus on the ticker implied volatility to plug the difference between risk-free implied value and premium charged.

* Primo’s definitely marginable

* Actually call option and broker margin arrangement are materially different in key areas. Indeed, these material differences compound the farther out the maturity. (1) Option buyer pays an upfront fee/charge/interest/whatever vs. periodically for borrower-on-margin (2) Option buyer’s worse case is upfront premium vs borrower’s is cumulative fixed charges plus the full $11.88 (so the disadvantage widens as maturity approaches, since full fixed charges are expensed) (3) no amount of delta exposure changes the actual downside scenario value of either

I think after my post on Kahala the stock traded at roughly $146 while expected value was roughly $159 for a spread of 8.9%. The current spread on this deal is now still 14.5%. I think the 5.6% point differential makes up for more than enough of some of the characteristics that are worse in this deal.

That was just the latest price of the stock when I published the article, but I didn’t buy it at that price and nor did anyone else after reading the article (turned out to be based on just one random small trade). Here the spread was actually a lot higher when I bought it, and also after publishing the article compared to KAHL.

Kahala post: ” this deal is the deal of the year, 22% spread!”. Glacier Water post: “Well, you couldn’t buy it there so actually this is the deal of the year.”. Curious to see how many deals of the year 2017 will bring. I hope many!

I think looking at annualized returns isn’t very important, the main risk event (the closing of the merger) is in two months time. What then remains sure will take some time, and will tie up some of your capital, but that’s it.

FWIW, your calculation of the annualized return is not correct, even if you assume that after vesting the warrants won’t be tradable and you have to hold them for five years I get an IRR of 18.6%. And having a high IRR over a longer period is way better than having a similar IRR on a shorter period because you have a massive amount of reinvestment risk: it will be hard to invest the cash that you get in deals that have a similar return. If you assume that the warrants can be sold as soon as they vest you get an IRR of 33%

I like your blog a lot!!! This is a really interesting idea. One question I have is whether you are going to short Primo. Because 71% of the stock compensation is held in escrow for an average of around 9 months after deal closing and because the warrants also don’t vest (and might not trade) for an average of around 9 months after deal closing, you have the challenge of deciding how to arbitrage out movements in Primo’s stock. Deciding how much Primo to short is also complicated by the possibility that there are claims against the escrow. A lot of your deal value is based on the value of the warrants; I also wonder how this is affected by your choice of whether or not to short some Primo. What do you think?

I think simply hedging the stock component of the deal, and not the warrant component is a good option. If you end up getting less stock than expected you are effectively still long since the warrants count for a decent amount of exposure, and if you hedge the stock component and Primo drops a lot you aren’t going to lose money. You just lose all the upside. Think that’s a decent way to approach it, although I’m not hedged at the moment.

The ability to hedge the PRMW exposure limits your concern about the escrow, correct? Normally I wouldn’t want to hold that long especially for merger arb when I don’t know the stock I’ll be getting that well. Also, do you know the cost to hedge?

I’m never that worried about having exposure to random things. As long as you are pretty sure that you enter trades with a positive alpha the remaining exposure will just be some noise (that probably has a positive expected value since stocks go up in the long run in general, and you don’t incur hedging costs).

Indeed the conditions to deal closure have been well structured by Goldman (GS really isn’t fond of missing out on success fees). That being said, if Primo’s stock begins dancing to the tune of Mr Market’s mixed emotions in the aftermath of the entertaining US elections, Jay may not look so apparently “clueless” in terms of both execution risk of new stock issuance and the merger arb upside (which of course in turn has a circular effect on the payout odds on offer).

He might be right (so far it doesn’t look like it) but for the wrong reasons. If you only look at the downside but refuse to think about odds for the deal passing or falling through .. Well lets just say you shouldn’t be involved in any merger at all if you reason that way.

Actually, he mentioned concern about both odds of deal closing and downside, not merely the latter. Now, I may disagree with Jay’s downside assumptions since I’m familiar with Glacier’s business and may think the odds of deal failure are relatively benign given how well Goldman’s structured conditions for deal closure, but lets just say concluding cluelessness over blog commentary is just….premature.

p.s. lol no man, it’s long Glacier / short PRMW. So if equity markets aren’t receptive to issuance of new PRMW stock, that wouldn’t be the hedge. Indeed, there’s no hedge against such scenario. Look, it’s a legitimate concern, just not the magnitude Jay said. That’s it.

He just mentioned he was worried about the deal closing but was not willing to give any specific odds. 17% upside 40% downside is as good as you are going to get in a merger situation so unless you have specific insights about why this deal should fail you are basically saying: “I don’t like merger arbs because they can go wrong”. Which is a useless boilerplate statement as far as I am concerned.

I am too ignorant to understand the second part of your post. Please enlighten me. “If equity markets don’t like issuance of new PRMW stock”, do you mean issuing stock for this deal? Issuing stock in general? Issuing stock in the future for exercised warrants? What risk cannot be hedged with shorting PRMW apart from the deal falling through?

“Also, if you are scared about the elections, just short PRMW.” Choppy/unreceptive equity markets in general and the deal’s likelihood of closure (which somewhat depends on ease of issuing Primo stock) are not independent events. Don’t think I mentioned warrants on this particular matter, so rhetorical questions were unnecessary.

Now, of course I’m going to call such a casual statement out as erroneous and set the record straight that you can’t hedge that risk simply by shorting PRMW, especially when it used as excuse to call someone clueless. Anyway, you answered your own question yourself in the above post, so applause, you’re not that ignorant. This post is becoming quite heated, so I’ll excuse myself from the comments going forward.

It wasn’t a rhetorical question, I really didn’t understand what you ment. If I understand correctly now you mean that the risk of the deal falling through could increase due to election uncertainty and that that is not something you can hedge by shorting PRMW?

If so, I agree but we’re talking past each other.

I think the far larger risk here is/was that the deal goes through but the market (and PRMW) trade down due to the elections (it’s a volatile growth stock) so you don’t make your 15%. That is the ‘election risk’ I was talking about and that risk can be managed by shorting PRMW.

I would estimate the chances of this deal falling through below 5% and even if you double that number, taking into account ‘election choppiness’, the risk/reward is still excellent.

You know that merger arbitrage is never a true arbitrage academically speaking since it’s not a risk-less profit, nevertheless in the financial world the term is used to describe a bet on a merger being completed.

And yes, 40% down is fantastical for a 17% gain. The only merger deals that you find with a spread like that have serious regulatory risks or other big problems, something this deal doesn’t have. The big question is, is the gain indeed going to be 17%. That’s where the risk is. Not in the completion of the deal.

What AlphaVulture means is that with 17% upside, 40% downside you break even if the deal fails ~30% of the time. I would say that the chances of this deal failing are _WAY_ lower than 30%. My guesstimate would be somewhere around 3% (small deal with no regulatory issues, insiders own majority of shares and will vote for it, roll-up makes sense for Primo) , leading to an expected value of ~15%. Even if you assume the deal falls through 10% of the time EV is still ~11%. Now, these calculations are simplistic but if you find any deal with better risk-adjusted returns please let me know!

On the other hand, if you refuse to or cannot answer question 2 there is no further point in discussing any deal at all ..

Could there be anti-trust issues in this deal? I know that in the cc in October management said that they thought they did not have to file for HSR approval, but that does not mean that the deal can’t be reviewed right?

I am no expert in this area, but i guess it depends on how narrow you define the market they operate in. If you would define it as ‘bottled water’ you have no problem at all as they compete with many many huge players like Coca Cola etc. However, if you define the market as ‘water dispenser bottles’ or ‘Water dispenser refill machines’ it seems that a leading player in the field (Glacier Water) is being acquired by another large player. Nestle is competing in some markets, but if you just google it, you see Glacier / Primo all over the place…

I think in general when antitrust reviews are done that they also look at the (close) substitutes that are available for consumers, and there are more than plenty here. If you define things extremely narrow at some point every company will have a 100% market share in something. I think the odds of antitrust issues showing up in this deal are extremely super remote (hope this successfully transmits how small I think this problem is 😛 ).

And yes, I think it’s correct that deals that don’t have to file for HSR approval can still be reviewed.

Yeah, I reasoned along the same lines. Just wanted to trow it out there in case someone with experience in that area had something to say about it 🙂 Thanks for the reply, and bringing this one to my attention!

I like the deal, solid rationale for completing the merger, not many roadblocks. It will carry the usual tail risk as in ‘economy sinks, buyer walks away’ but given the strong economic rationale behind the deal, and the short timelines to closure, I think the chances of that materializing are very very small

Didn’t see anything shocking. Cash part is now estimated to be $12.17, GWSV has not incurred additional debt since the merger was announced.

Nice to read in a footnote on page 103: “[..] the fair value of the warrant to purchase 2.0 million shares of Primo common stock of approximately $9.5 million, determined using the Black-Scholes valuation model.”, so approximately in line with your estimate.

Good to see, even though it’s just a small increase 🙂 I do wonder though if they will still be able to complete the merger this year since the consent solicitation statement is still a preliminary one.